» Return to Asset Allocation Models
Up to this point, the risks and return potentials of the three categories have been viewed individually. However, the most efficient investment portfolios are based on an overall approach that examines the risks and return potential of your total portfolio, not just the individual parts. Diversifying among the asset categories reduces the individual category risks, and allows you to build a portfolio that matches your investment profile.
Your investment profile includes your tolerance for risk; your return needs, whether long-term real growth or income; your time horizon; and your tax exposure.
How can you analyze the risk and return potential of a portfolio?
To start, the historical data is used here as one possible guide, with the qualification that the future may vary.
Risk tolerance:
Use the worst-case scenario—the maximum loss for all categories—as a guide to how much of a loss you can stomach.
In the examples here, the worst one-year holding period returns are used.
Return needs:
The average annual returns for the entire period, average annual growth and the average income figures can be used to help
assess your growth and annual income needs, but keep in mind they are long-term figures; variations year-to-year can be significant.
Bonds and cash produce a steadier source of income than do stocks; a much larger percentage of their annual return comes from income rather than growth. Cash has the advantage of immediate liquidity, but the disadvantage of lower levels of income.
Don't rule out stocks entirely when considering income needs. Dividend income is usually lower than bond income at any given point in time, and dividends are also less assured than bond yields, but the long-term average is not unattractive. Also, it isn't necessary to rely on an income component if you need annual income. You could instead invest for maximum total return, keep a portion in cash for liquidity, and sell stock when necessary.
Stocks clearly are a better source of growth, as well as having the ability to substantially outpace inflation.
Time horizon:
The various holding period returns indicate the kinds of risk you face based on your own time horizon. If you are investing
only for a short time period, you should not be invested in the stock market, given the substantial losses historically.
On the other hand, the risk/return equation increasingly favors stocks over longer holding periods. Historically, the worst returns for stocks substantially improved the longer the holding period, while for bonds and cash it remained roughly similar. For 20-year holding periods, the worst return for stocks—6.5%—was not much lower than the best return for cash over that period, and was considerably higher than the worst return for either bonds or cash.
Tax Exposure:
Taxes will hurt your bottom line returns, but there are ways to reduce their impact based on how much you can shelter through
tax-exempt accounts (such as IRAs) and specific types of investments (such as municipal bonds). At this stage, however, don't
worry about them.
